Special Report
Highlights A decade after the financial crisis, yield remains scarce: The global count of bonds trading at negative yields seems to grow every week, squeezing a broad swath of investors who are desperate for coupon income. Increasingly accommodative monetary policy is not on income investors’ side, … : Dovish pivots from the Fed and the ECB ensure that low-to-negative yields won’t go away soon. … but it is quite friendly for maturity transformation strategies in the near term: Borrowing short to lend long is far from a fail-safe strategy, but it should dovetail nicely with reflationary Fed policy for at least the rest of the year. The time is ripe for returning to the agency mortgage REITs: Among public securities, agency mortgage REITs offer the most direct exposure to maturity transformation. Feature Economic data and corporate earnings releases remain mixed enough to provide both bulls and bears with ample support for their leanings. The debate within BCA remains spirited, and is emblematic of the debate among investors. Per the financial media, it seems as if the scolds are getting the most attention,1 even as the S&P 500 keeps setting new highs. One thing that both camps agree on, however, is that nothing is cheap. Equities are not terribly expensive, but bonds appear to have little chance of matching their historical return profile. Investors seeking income, from individuals and advisors, to pension funds, life insurers and endowments needing to meet a fixed schedule of liabilities, are under siege a decade into ZIRP and NIRP. With rate cuts on the horizon in the U.S., and the ECB preparing to ramp up accommodation, the pressure on income-seeking investors to throw caution to the wind and ignore credit quality shows no sign of abating. Maturity transformation – borrowing short to lend long – fits the Fed’s reflationary goals like a glove, and offers an alternative to abandoning credit standards. Contrary to popular belief, banks no longer pursue maturity transformation. Chastened by the savings-and-loans’ demise in the ‘80s, they make heavy use of swaps to keep a tight rein on asset-liability mismatches. Maturity transformation is agency mortgage REITs’ raison d’être, however, and aside from some hedging to ensure survival in the face of adverse interest-rate moves, they actively embrace it. The Agency mREIT Formula Mortgage REITs (“mREITs”) finance real estate investment, either by lending directly to property owners or by purchasing mortgages and/or mortgage-backed securities (“MBS”). Agency mREITs invest solely or predominantly in instruments issued or guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae. MBS issued by these entities are explicitly backed by the full faith and credit of the United States and bear little to no credit risk. The agency mortgage REITs stumbled ahead of all four of the yield curve inversions they’ve experienced, and six years of flattening has ground down their share prices. Despite the negligible credit risk in their investment portfolios, agency mREITs themselves are far from riskless – leveraged carry trading strategies are not for the faint of heart – but they have performed much better than non-agency mREITs, some of which go bust in every cycle. The agency mREITs are a much purer play on the term structure of rates than their non-agency peers. Their borrow-short-to-lend-long model is intentionally designed to exploit the yield curve’s typical upward slope. Though they stumble ahead of inversions (Chart 1), they are an attractive portfolio component when the fed funds rate outlook is benign and the curve is poised to steepen. Chart 1The Steeper The Better Banks are happy to lend against pristine collateral for short timeframes, allowing agency mREITs to build RMBS portfolios 10 times the size of their equity capital. Figure 1 illustrates the mechanics of building an agency mREIT portfolio. A new mREIT first raises equity in a public offering and uses the proceeds to purchase a portfolio of agency-backed residential MBS (“agency RMBS”). It then uses the portfolio as collateral for a secured repurchase (“repo”) loan, typically with a 30-, 60- or 90-day term, the proceeds of which it recycles into more agency RMBS. With banks and brokers lending 95 cents on the dollar against agency collateral, an agency mREIT can easily amass asset portfolios several times the value of its equity capital. As long as portfolio income exceeds the sum of repo interest and operating expenses, it will be profitable. Table 1 lists all of the constituents of our Agency Mortgage REIT Index since its 1998 inception, along with the current constituents’ price-to-book multiples, dividend yields, betas versus the S&P 500 and leverage ratios. As a group, the agency mREITs have high dividend yields, low equity betas and considerable leverage. Table 1Agency Mortgage REIT Index Constituents Low beta and high leverage could be a nice mix when the economy is mushy and the Fed and other major central banks are ramping up accommodation. Then And Now The last time we recommended the agency mREITs (June 2011 through September 2012), they handily outperformed the S&P 500 and the Bloomberg Barclays High Yield Index on a total return basis (Chart 2). Uninspiring growth and easy monetary policy proved to be a potent mix for agency mREIT outperformance. The backdrop looks similar to us now, and we expect that the agency mREITs will outdistance high-yield corporate bonds over the rest of the year. They may be hard-pressed to top the S&P 500 under more constructive economic and market scenarios, but they should help protect other equity exposures in the event that economic growth and equities slump. Chart 2The Agency Mortgage REITs Boosted Our Returns In 2011-12, ... The Incredible Shrinking Stock Price Agency mREITs trade on their price-to-book multiples, but REIT rules leave the companies with little chance to grow book value. REITs have to distribute 90% of their annual income to shareholders to maintain their tax-preferred status, and they pay no income tax at the corporate level if they distribute all of it. The upshot is that mREITs have no retained earnings, which stymies them from growing book value. In exchange for optimal tax efficiency, REITs give up the potential to compound their way to growth. Chart 3...But They've Run Into Headwinds Since Price-to-book multiples swung wildly in the group’s first decade, but have settled into a tight post-crisis range (Chart 3). If book value can’t grow, and multiples are capped around 1, stock price appreciation is unlikely to contribute to total returns. History suggests that investors should actually expect some modest drag from capital losses; all but one of the stocks in our Agency mREIT Index have declined since their inclusion2 (Chart 4). The drag follows from the constraints of the REIT rules; companies that can’t retain earnings and have already reached their borrowing capacity can only grow by issuing stock, but companies only receive about 95% of the proceeds from offerings after underwriting fees.3 The practical takeaway is that the agency mREITs are not a through-the-cycle play, and investors should only add them to their portfolios when they are comfortable that price declines are not likely to undermine dividend distributions. Honey, I Shrunk The Share Price. Agency mREIT Vulnerabilities The agency mREIT model has three inherent vulnerabilities: it relies on maturity transformation, it employs copious amounts of leverage, and it has convexity working against it. None is likely to prove fatal for entities that are reasonably prudent about hedging rate exposures, limiting leverage, and guarding against prepayments, but double-digit annual returns are not pre-ordained. Each management team makes its own hedging choices, but all agency mREITs maintain considerable duration mismatches. Unexpected changes in the term structure of rates have the potential to upend shareholder returns. Chart 5Repo Funding Is Reliable Our index constituents have a considerable amount of leverage. With 5-cent haircuts on agency repo financing, mREITs can theoretically build an agency MBS portfolio equivalent to 20 times the value of its equity capital. Maximal leverage would leave very little room to maneuver under duress, but leverage around ten times has not historically posed a problem. Given that agency MBS is gilt-edged collateral, we expect that the agency mREITs will be able to roll over their repo financings in a stress scenario, just as they were able to amidst the crisis (Chart 5). Interest rate volatility is also a headwind, independent of the level of rates. Under standard U.S. mortgage terms, MBS investors implicitly grant options to borrowers by allowing them the unlimited right to prepay their obligations without penalty (see Box). Options increase in value as the volatility of their underlying reference asset increases, so MBS values move inversely with changes in interest rate volatility. The good news for the mREITs is that increasingly accommodative Fed and ECB policy should act to tamp down rate volatility in the near term. The agency mREIT model proved its resiliency at the height of the crisis. Even in times of peak stress, it’s possible to borrow against the best collateral. Box An Equity Investor’s Guide To Negative Convexity Even for fixed income lifers, mortgages can be a dauntingly complex product, largely because of borrowers’ ability to prepay their loans, without penalty, at any time. This prepayment option gives mortgages and MBS what fixed income professionals call “negative convexity.” Long-duration, non-callable bonds are said to be positively convex. That is, their value increases at an increasing rate as interest rates fall and decreases at a decreasing rate as interest rates rise. Mortgage borrowers’ prepayment option prevents mortgage lenders from enjoying the full effect of convexity because the more the present value of a mortgage’s future payment stream rises as rates fall, the less likely lenders will realize it as savvy borrowers refinance into one offering a lower interest rate. This effect is called negative convexity and it is why mortgage investors must be compensated with higher yields. Fannie, Freddie and Ginnie securities therefore yield more than Treasuries, even though both are backed by the full faith and credit of the U.S. Treasury. With the exception of 2018’s backup, mortgage rates are where they’ve been since late 2014. There may not be many more loans worth refinancing. An unexpected rash of refinancings (“refis”) would squeeze agency mREIT income via mark-to-market losses and unwelcome exposure to reinvestment risk. More borrowers refi when rates decline, squeezing earnings, and cutting into, or even potentially wiping out, the benefit of lower funding costs. Although refi application activity has not always exhibited a tight correlation with agency mREIT returns, refis are a threat to agency mREIT earnings. Although we expect rates to remain in a fairly narrow range consistent with mushy growth and quiescent inflation expectations, it is our sense that they have bottomed and that refi activity, in turn, has already peaked (Chart 6). Chart 6Prepayments May Be Ready To Taper Off Why Now? An equally-weighted basket of agency mREITs has outperformed both the S&P 500 and the Bloomberg Barclays High Yield Corporate Bond Index by two-and-a-half percentage points (“ppt”) on an annualized total return basis over its 21-plus-year history (Chart 7). They do not always outperform, however, and since we closed our position at the beginning of October 2012, the agency mREITs have lagged large-cap equities and high-yield bonds by ten-and-a-half and three ppt, respectively, on an annualized total return basis. Chart 7The Agency REITs Have Had A Strong Career, But The Last Seven Years Have Been Rough Rising rates and curve-flattening normally spell the end of agency mREIT outperformance, but we feared in the fall of 2012 that the Fed was killing the group with kindness. Ultra-accommodative policy encouraged refis while the Fed itself was actively bidding up agency MBS prices with QE3. Refis impaired the value of the legacy portfolios because they triggered losses on positions that had been marked-to-market above par. Higher prices helped the legacy portfolio holdings but forced the mREITs – in the midst of an epic three-year run of capital raising via secondary equity offerings – to put new capital to work at the top of the market. The policy backdrop appears more conducive to relative agency mREIT outperformance now. Faced with sluggish global growth and stubbornly low inflation expectations, the Fed is poised to cut rates for the first time since 2008. We expect the Fed will deliver a 25-basis-point cut at the conclusion of tomorrow’s FOMC meeting, and another one in September, and then refrain from hiking again until at least the first quarter. Nothing outperforms forever. The agency mREITs make a much better cyclical investment than a structural investment. Reflationary monetary policy should produce a steeper curve as growth and inflation expectations revive (Chart 8). A steeper curve will boost agency mREITs’ earnings by widening their net interest margins, allowing for increased dividend payments and fatter total returns. Given that we expect curve steepening, we do not worry that rate cuts will spark a wave of prepayments. As Chart 6 showed, 2018-vintage mortgages would seem to be the only ones issued over the last five years that are worth refinancing. Chart 8Rate Cuts Typically Promote A Steeper Curve Investment Implications Reflationary policy is a good backdrop for agency mREIT performance because it’s likely to promote a steeper curve. A steeper curve is manna from heaven for maturity transformation strategies, and it would boost mREIT income while reducing the potential for the capital losses that eat away at double-digit dividend yields. We are not counting on capital gains, but if peak inversion is behind us, the group’s multiple has a chance to expand. The bottom line is that several factors may have come together to bring the curtain down on the agency mREITs’ extended underperformance. We recommend that investors stick to the constituents in our index basket if they choose to add agency mREIT exposure to their portfolios. The leading mREIT ETFs, REM and MORT, provide one-stop access to the mREIT universe, but they come with considerable non-agency and commercial exposure. We are constructive on credit performance, but we think the best opportunities reside in the pure-play maturity transformation offered by the agency mREITs. We recommend funding agency mREIT exposure in balanced portfolios by diverting allocations from equities and high-yield positions. We plan on holding the mREITs for six months for now, but we’re open to staying with them longer. We expect that agency mREITs will boost risk-adjusted returns at least until the Fed first hikes again, and possibly even longer if inflation expectations revive. We therefore intend to maintain agency mREIT exposure through the end of the year, and are open to holding onto it for longer if conditions remain supportive. Our initial six-month recommendation in June 2011 remained in place for sixteen months, and we’d be pleased if this one had similar staying power. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 De Aenlle, Conrad, “Is It Time to Fight the Fed?” New York Times, July 14, 2019, p. BU13. The experts quoted in the lead article in the Times’ latest quarterly mutual fund and ETF section were uniformly bearish on U.S. equities, in keeping with the author’s “iffy-to-awful” characterization of the economic backdrop. 2 Dynex (DX) is only included in our index from the beginning of 2001, when it switched to a pure agency strategy after nearly capsizing. Since its 1988 IPO, DX’s stock price has shrunk at an annualized rate of 3.9%. 3 The built-in drag from issuance is exacerbated by the lamentably common industry practice of issuing stock at a discount to book value, which dilutes incumbent shareholders’ investments.
